Practice Pricing Foreign Exchange Option Contracts

Option contracts are financial contracts that give the buyer the right, not the obligation, to buy or sell a quantity of a particular currency at a specific exchange rate, called the strike rate, on or before a pre-arranged date. A call option is the right to buy a particular currency, and a put option is the right to sell a particular currency. An option is a right, not an obligation, so it will be exercised only when it is favorable to do so.

An option is comprised of two value drivers, (1) intrinsic value, which is the difference between the strike rate on the contract and the then prevailing spot rate in the market, and (2) time value, which is any excess value beyond intrinsic value related to time to maturity.

A purchased option begins its life as an asset in the amount of the option premium paid to the counterparty at inception, typically purely time value, and will expire with a either a positive intrinsic value or zero fair value. When intrinsic value is positive, it is referred to as “in the money” since the strike rate is more favorable than the spot rate, and when intrinsic value is zero is referred to as “at the money” if the strike rate is equal to the spot rate or “out of the money” if the strike rate is less favorable than the spot rate.

Options, when hedging, secure the value of an underlying position, providing 100% protection against unfavorable market moves beyond the strike rate, while retaining 100% participation in favorable market moves, which may justify the premium paid. Options tend to be used most frequently for longer dated exposures such as forecasted transactions, since the greater the timeframe, the greater the potential for the market to move materially, which creates greater potential to participate in favorable market movements.

Options are also attractive for scenarios where there is uncertainty the exposure will materialize, such as a bid to award contract or a forecasted acquisition, since an option is a right, not an obligation. Options provide a high degree of certainty and the greatest degree of flexibility, but are employed less frequently in practice when hedging due to the premium paid up front.

In order to price an option contract, a number of option pricing models can be used in the marketplace, but currency options are priced most often using the Garman-Kohlhagen option-pricing model. The Garman-Kohlhagen option-pricing model is a complex equation that takes into account the following six variables:

1. The spot foreign exchange rate
2. The interest rate on the base currency
3. The interest rate on the terms currency
4. The strike rate of the option
5. The time to expiration
6. The volatility of the currency pair.

To illustrate the concept of an option contract, this Foreign Exchange Derivative Speculator can model the economic and accounting aspects of both a put and a call option. The first step is to select a long position, which represents a call option to buy the currency, or a short position, which represents a put option to sell the currency. The next step is to enter the parameters of the trade, which includes specifying the currency pair, spot rate, trade date, expiration date, notional amount, and currency quoting convention.

In step 2, select an option contract as the foreign exchange derivative instrument, and enter the pricing variables outlined above, which include the domestic and foreign interest rates, the strike rate (which is the exchange rate that the option contract can be exercised at), and the volatility of the currency pair. You can change any of the option variables to instantly see the impact on the premium, or cost, of the option contract.

For example, adjusting the strike rate lower or higher will increase or decrease the premium of the option contract. Similarly, changing the level of implied volatility in the currency pair impacts the price of the option as well, whereby the more volatile the currency pair, the more expensive the option premium.

In step 3, the ending spot rate can be adjusted to see how changes in the spot rate on the expiration date impact the economic value of the option contract. This tool demonstrates how the option will only be exercised when the strike price is more favorable than the ending spot rate. If the ending spot rate is more favorable for buying or selling the currency than the strike rate, the option finishes "out of the money" such that the maximum loss on the contract is the premium paid. Conversely, if the ending spot rate is less favorable for buying or selling the currency than the strike rate, the option finishes "in the money" and equals a positive value.

You can practice pricing foreign exchange options using the Foreign Exchange Derivative Speculator to illustrate the economics and accounting of an option contract, both a put and a call, and to see how variables such as the option strike rate and implied volatility impact the premium or cost of the option at inception. Additionally, you can explore how options can finish "in the money" where a cash payment is received at maturity, or "out of the money" with a zero fair value where no further payment is required to settle the contract.

Take advantage of this unique learning resource to discover the three key distinguishing characteristics of vanilla option contracts, which include (1) the premium paid upfront, (2) the asymmetrical payoff profile relative to the spot foreign exchange rate, and (3) the lack of obligation to make a payment at maturity.

If you are interested in learning more about option contracts, sign up for FX Initiative's Currency Risk Management Training and benefit from our educational videos and interactive examples. Our course on Foreign Exchange Spot & Derivatives walks you through real-world examples of using derivative instruments, and leverages our Foreign Exchange Derivative Speculator to illustrate essential concepts. Foreign exchange options pricing can be complex, but our approach simplifies the academic theory and focuses on the practical application of using options to help your international organization achevei their foreign exchange risk management objectives.

Ready to practice pricing foreign exchange options? Click here to get started!

Cheers,

The FX Initiative Team
support@fxinitiative.com

Due Diligence & Distinguishing FX Derivatives

Due diligence is a term that commonly applies to a business investigation, and it contributes significantly to informed decision making by assessing the costs, benefits, and risks of a transaction. As due diligence relates to foreign exchange (FX) risk management, firms can enhance their strategic decision making process by assessing the costs, benefits, and risks associated with currency derivatives, and recognizing their differences and similarities when hedging foreign currency transactions.

At the highest level, currency derivatives are financial contracts between two parties whose value is derived from the exchange rate of one or more underlying currencies. FX risk management involves mitigating currency risk to an acceptable level by understanding when and how to hedge using FX derivatives to achieve FX objectives. The first part of the FX risk management decision making process is determining a firm’s FX hedging objectives and strategy for achieving those objectives.

The two most common FX risk management hedging objectives are (1) minimizing foreign exchange gains and losses in earnings and (2) preserving cash flows. The most common currency derivatives used in practice are (1) forward contracts, (2) vanilla options, and (3) zero cost collars. Therefore, to achieve the 2 most common hedging objectives using the 3 most common currency derivatives, it is helpful to compare and contrast how each derivative achieves each hedging objective as follows:

1) Forward Contracts

• Objective 1: Minimizing Earnings Volatility - Forwards are particularly attractive for firms that seek a symmetrical payoff profile relative to the spot foreign exchange rate, where the hedge achieves largely equal and offsetting gains and losses related to the underlying foreign exchange exposure. Forwards are by far the most effective derivative for eliminating foreign exchange gains and losses to the greatest extent possible, and are used overwhelmingly in practice for all types of FX hedges.
• Objective 2: Preserving Cash Flows - Forward contracts do not require an upfront premium to be paid, unlike an option. However, a forward contract will almost always finish in either an asset or liability position at maturity depending on the ending spot rate, which may require a cash payment to be made in the future to settle the contract.
• 3 Distinguishing Characteristics: 3 key distinguishing characteristics of forward contracts are their forward point premium or discount, the lack of upfront cost, and the symmetrical payoff profile relative to the spot foreign exchange rate.

2) Option Contracts

• Objective 1: Minimizing Earnings Volatility - Options are particularly attractive for firms that seek an asymmetrical payoff profile relative to the spot foreign exchange rate, where the hedge secures the value of an underlying position against unfavorable market moves beyond the strike rate, while retaining 100% participation in favorable market moves. Options do not provide the same degree of offset in earnings as a forward due to its asymmetrical payoff profile, and tend to be used for longer dated and/or uncertain exposures.
• Objective 2: Preserving Cash Flows - A purchased vanilla option requires a cash premium to be paid to the counterparty at inception, which can be a deterrent compared to a forward contract. However, an option will always expire with either a positive intrinsic value or zero fair value at maturity, ensuring no future cash payment is required by the option holder to settle the contract.
• 3 Distinguishing Characteristics: 3 key distinguishing characteristics of vanilla option contracts are the premium paid upfront, the asymmetrical payoff profile relative to the spot foreign exchange rate, and the lack of obligation to make a payment at maturity.

3) Zero Cost Collars

• Objective 1: Minimizing Earnings Volatility - Zero cost collars are particularly attractive for firms that seek to establish a predefined range of foreign exchange rates where the value of the hedged FX transaction is secured on the downside by the collar “floor” and limited to the upside by the collar “ceiling" or "cap”. Zero cost collars provide less downside protection and less of an offset in earnings relative to a forward contract, but allow for participation in favorable market moves like an option contract with no upfront premium.
• Objective 2: Preserving Cash Flows - Zero cost collars do not require an upfront premium to be paid by combining two vanilla options, (1) a purchased out of the money option and (2) a sold out of the money option, whereby the premium paid on the purchased option is offset by the premium received from the sold option to create a zero cash outlay. However, a collar has the potential to finish in a zero fair value, asset or liability position at maturity, which may require a future cash payment to be made to settle the contract.
• 3 Distinguishing Characteristics: 3 key distinguishing characteristics of zero cost collars are the ability to participate in favorable foreign exchange rate movements with no upfront cost, the reduced downside protection relative to a forward contract, and the unique payoff profile of the collar range relative to the spot foreign exchange rate.

Overall, each company must decide their FX hedging objectives and strategy for achieving those objectives that balances minimizing earnings volatility and preserving cash flows. There is no one prescribed method for selecting a FX derivative, and firms can benefit by approaching the selection of a derivative from a hedge objective perspective. As the late, great economist Milton Friedman said, “there is no free lunch” in economics, and when selecting a FX strategy, firms can benefit from recognizing the tradeoffs, differences and similarities of how the 3 most common currency derivatives can be used to achieve the 2 most common FX hedging objectives.

To learn more about FX derivatives, you can explore our previous blog post on “How to Compare Currency Derivatives & Credit Considerations” and sign up for FX Initiative’s currency risk management training. Our FX Spot & Derivatives Course deconstructs forward contracts, option contracts, and zero cost collars to help you select an optimal hedge instrument. Additionally, our FX Derivative Speculator illustrates the economics and accounting of derivative positions to compare and contrast the payoff profiles, cash flows and accounting entries under virtually any FX rate scenario. Start doing your derivative due diligence today by taking the FX Initiative!

Are you curious how forwards, options, and zero cost collars work in practice? Click here to learn from real-world examples!

Cheers,

The FX Initiative Team
support@fxinitiative.com